Don’t Get Caught Napping as Volatility Takes a Snooze

Mike Larson | Friday, May 30, 2014 at 7:30 am

My daughters are getting older. One will be entering the third grade this fall and another — gulp! — is going into middle school. But I will always cherish the memories of when they were little, including reading to them before bed.

One of my favorite stories was called “The Napping House.” The basic plot? A bunch of human and animal characters are snoozing and snoring away, blissfully unaware of any possible threats or disturbances. Then a tiny flea decides to bite a mouse — and everything goes to heck in a handbasket!

I thought of that story this week for a simple reason: It’s investors who are snoozing right now. Bond investors. Stock investors. Foreign exchange and commodities traders. They’ve all been lulled into the deepest snooze I’ve ever seen.

Bank and brokerage firms like JPMorgan Chase have warned that trading revenue will continue to suffer.

You can see this by looking at measures of market volatility. Take the Chicago Board Options Exchange SPX Volatility Index, or “VIX” for short. It’s a measure of investor complacency and calm, as measured by the options market. The lower the VIX falls, the less risk of large swings (especially downside ones) that investors are pricing in.

Take a look at this monthly chart of the VIX and you’ll notice something. We’re trading around 11-12. That’s roughly half the long-term historical average, and at levels that signal maximum complacency.

The last time we saw anything like this? Late 2006-early 2007 … right before the housing, credit and stock markets began to collapse and volatility began to explode.

It’s not just stock traders who are dozing on the job, either. Volatility has collapsed in virtually every capital market on the planet.

Just look at the “MOVE” Index, which tracks Treasury bond market volatility. It has sunk all the way to around 55. We’ve only seen bond volatility fall to levels this low three other times in the 26-year history of the index:

Mid-1998 … right before the gun-slinging hedge fund Long-Term Capital Management collapsed. That forced the Federal Reserve to convene a meeting of all the major brokerage firms in New York City in order to arrange a multi-billion-dollar bailout. At the time, it was the biggest such bailout ever!

Mid-2007 … right before the credit market began to collapse. That implosion ultimately required hundreds of billions of dollars in bailouts for companies like AIG, Bear Stearns, Fannie Mae, Freddie Mac, Citigroup, and Bank of America — bailouts that made the LTCM collapse look like child’s play!

Mid-2013 … right before the first, massive “Taper Tantrum” that led to the biggest bond market rout in several years.

For investors like you, this lack of volatility has a couple of important implications:

First, it’s a key reason why CEOs, CFOs, and other officials from major bank and brokerage firms like Citigroup (C), JPMorgan Chase (JPM), and Goldman Sachs Group (GS) have warned that trading revenue will continue to suffer. After all, as the Wall Street Journal noted on Tuesday, no volatility = much weaker profits. I continue to recommend you steer away from investing in most of these institutions as a result, and would note that they’re all underperforming the market.

Second, it’s a potential “yellow flag” for the markets overall. I’ve been helping my Safe Money subscribers generate nice gains from this low-volume, low-volatility rally. And I still like many of the sub-sectors they’re invested in, from domestic energy to aerospace.

If you’re one of them, great. I’ll have more on your positions in your next monthly issue, due out next week. If you’re not on board yet, but would like to join, all you have to do is click here.

But in light of the collapse in volatility, I’ve started harvesting gains on positions that have run up quite a bit. I’ve also gotten more selective in adding new equity exposure. Because just like the characters in “The Napping House,” many investors out there are acting like there are no potential “fleas” at all … something that makes the contrarian in me increasingly nervous and wary of hidden threats.

Until next time,

Mike

Mike Larson graduated from Boston University with a B.S. degree in Journalism and a B.A. degree in English in 1998, and went to work for Bankrate.com. There, he learned the mortgage and interest rates markets inside and out. Mike then joined Weiss Research in 2001. He is the editor of Safe Money Report. He is often quoted by the Washington Post, Reuters, Dow Jones Newswires, Orlando Sentinel, Palm Beach Post and Sun-Sentinel, and he has appeared on CNN, Bloomberg Television and CNBC.